Collateral: Transforming

Counterparty Risk into Legal and

Operational Risks

Robert McWilliam

Head of Counterparty Exposure Management

5 Years Ago…..

Collateral reduced credit losses during Asia, Russia

and Hedge Fund ‘crisis’ in 1997/98

ISDA estimated $200bn collateral assets

9 ISDA Collateral opinions

High thresholds linked to credit worthiness

Calendar driven or mtm margin calls

Weekly/monthly margin frequency

Single product margining

ISDA 1999 Collateral Review

Reduction in time frames associated with call cycle

and substitutions

Revised dispute resolution procedure

Broadening of scope to include reconciliation and

exchange of information

Simplification of definitions and language

Simplification of document architecture

While collateral reduces credit risk, it simultaneously increases other risks to which banks are exposed, such as legal, operational, liquidity and market risk. Therefore, it is imperative that banks employ robust procedures and processes to control these risks.

The New Basel Capital Accord , January 2001

Basel II

Funding Corp bonds, Equity Govt Bonds

Industry Opinions BespokeLegal

High ThresholdInfrequent Calls

Zero ThresholdDaily Calls

Operations

Documentation GMRA, ISDA Client Driven

Portfolio Passive Active

Settlement Govt Bonds, Cash Corp Bonds, Equity

Low Cost High CostRisk

Legal and Operational Risks

Is the Collateral Yours to Keep?

Perfection and enforcement risk for pledges

Re-characterisation risk for title transfer

Uncertainty under conflicts of law rules as to

which law applies

Vulnerability to third parties

Enforceability of “top-up” deliveries

ISDA Collateral Agreements

Operational Provisions

Legal Provisions

Definitions

Elections Supplement

New York Pledge

English Transfer

English Deed

Japanese Pledge/Loan

Time Frames

3 day call cycle: Value - Notify - Settle

Contrast FX Margin, Repo markets

2 day substitution: Deliver - Return

Double-up credit risk overnight

Market practice may differ from CSA terms

Increased legal risk??

CSA Para 4 - Dispute Resolution

(1) Disputing party to notify other party by close of business on the LBD following the date that the demand is received

(2) transfer the undisputed amount

(3) parties to consult in an attempt to resolve the dispute

(4) if they fail by the Resolution Time, then:(i) Valuation Agent to seek 4 actual mid-market quotes

(ii) recalculate collateral value pursuant to 11(e)(ii)

Following recalculations, Valuation Agent will notify each party not later than Notification Time on LBD following Resolution Time

Failure to make the required transfer results in an Event of Default under ISDA Master Section 5(a)(i) ‘Failure to Pay or Deliver’ subject to a standard 3 day cure period.

Reconciliation

Agreement terms

Thresholds, Rating triggers, Collateral eligibility and haircuts

Population matching confirmations

Valuation differences:

OTC transactions cashflows, rates, curves, vol smile…

Collateral assets coupons, prices, pre-payments

Settlement and custody

AGREEMENT DATA

CUSTOMER REFERENCE DATA

COUNTERPARTY DATA

STATIC DATA

COLLATERAL ASSET DATA

TRANSACTION DATA

MARKET DATA

Collateral System

Data Requirements

Portfolio Risks

Liquidity and volatility

Collateral eligibility and haircuts not sensitive to market

Concentration

Within portfolio and across the firm

Correlation of your counterpart with:

Issuer of collateral asset; “two-party pay” risk

Market events

CUSTODY

DATA MANAGEMENT

CONFIRMATIONS

PAYMENTS

RISK & LEGAL

FINANCIAL CONTROL

TRADING DESK

Margin Team

Communications Centre

Funding Active re-use, cross product margining

EU Collateral Directive, Hague ConventionLegal

Continued investment in systems and peopleCentral Counterparties, Outsourcing

Operations

Documentation ISDA Margin Provisions 2001, GMRA 2000

Portfolio Wider collateral acceptance

Settlement Consolidation of platforms

Changes in Market EnvironmentRisk

Trends in Collateral Use

Collateral Market - Today

$719bn collateral assets

70% cash, 13% govt bonds, 17% other

38,500 collateral agreements

54% Americas, 24% Europe, 10% Caribbean

26% banks, 22% investors, 19% hedge funds, 17% corporate

50% fixed income derivative exposure collateralised

70% support Repo, 33% FXMargin, 28% Sec Lending

33 ISDA collateral opinions

And the Future….

Collateral is much more widely used

New entrants; insurance/pension funds, corporate, emerging markets

Tighter credit terms; zero threshold, daily calls

Risk based margining across wider product range

Improvement in collateral risk management

More highly skilled practitionersimproved business process

Better technology support

ISDA initiatives: Electronic Date Interchange, Asset Definitions, Guideline update, revised CSA, Law reform…

New tools to manage counterparty risk: CDS, Tear-ups, Third Parties